Profit seems like a pretty basic concept — it’s the amount of money you make. But after you’ve owned a business for a while, you come to realize just how many ways there are to explain the money you’ve made.
Keeping track of all of the different types of profit helps prove that the concept of profit isn’t as easy as it seems. There are different levels of profit that all address how much money you made—if any.
Knowing these terms can help you make informed financial decisions that optimize profitability for whatever type of profit you care most about. Start by learning the differences between gross and net profit and what they mean for your financial reporting.
Gross profit is how much of revenue remains after you’ve taken out the costs of making and selling your products or services. It’s expressed as a dollar amount, naturally, which allows you to see a pretty clear picture of how efficiently your business operations are running.
To calculate gross profit, however, you need to know two other concepts: net sales and cost of goods sold.
Net sales refers to the amount of revenue made after subtracting discounts, refunds, and other allowances.
Cost of goods sold (COGS) are the direct expenses associated with each good or service you sell (i.e., the cost of manufacturing or acquiring your goods). Note that these do not include indirect costs, such as rent for your office.
For example, if you make $100,000 in sales for the quarter and had $5,000 in returns, then your net sales are $95,000. If it cost $25,000 to buy the materials for your products and assemble them (your COGS), then your gross profit is $70,000.
Net Sales – Cost of Goods Sold = GROSS PROFIT
($100,000-$5,000) – $25,000 = $70,000
With this starting formula, you can gain visibility into your profitability by first removing the cost of goods sold.
Here’s an example of gross profit in action. Let’s say your business makes and sells baby strollers. Your cost of goods sold might include the materials you use to make the strollers, including wheels, handles, fabric, and anything else; the labor required to create the strollers, including people on the production line and your sellers; and the equipment used in the process. If you ship the baby strollers to customers, you’d add those costs in as well.
Once you’ve tallied all your costs related to the goods you sold, you’d subtract that amount from your net sales. What remains would be your gross profit. Use it as the first step in understanding whether your business is (or isn’t) profitable.
Net profit is the next step beyond your gross profit calculations. Your COGS don’t cover all of your expenses. Operating expenses like rent, utilities, office supplies, marketing costs, payroll, and insurance all fall outside of COGS.
However, these are very real expenses that impact your profits—which is why you need a formula to calculate net profits, too.
To calculate your net profit, take your gross profit and subtract operating expenses. This will result in your net profit, or the actual amount of money you made that quarter.
Since we already calculated our gross profit at $70,000, now we’ll subtract our operating expenses, which were $20,000, then your net profit is $50,000. From the original sales number of $100,000, you can learn that your profit is actually half of your sales.
Gross Profit – Expenses = NET PROFIT
$70,000 – $20,000 = $50,000
Net profit is also expressed as a dollar amount, which makes it feel very tangible. Convenient, eh?
Net profit gives a truer picture of the money your business is making. Let’s say your baby stroller business has the opportunity to move to a new production facility where the rent is one-half the cost of your currently location. Using the formula above, we’ll say rent was $10,000 of the $20,000 in expenses. That will definitely have an impact on your net profit … So you plug in the new cost of rent ($5,000). Ca-CHING!
$70,000 – $15,000 = $55,000
But then you learn that the utilities and insurance costs on that location are more than double what you paid at your current stroller facility, plus you’ll have building maintenance fees as well as security fees that you didn’t have before. In total, this part of your expenses increases from $2,500 to $8,500. After plugging in those numbers, too, you would see that your net profit would decrease by making the move.
$70,000 – $21,000 = $49,000
It’s great to know your gross profit because it helps you determine your net profit. But as you’ve probably noticed in business, no calculation is an island — your net profit helps you take the next step: calculating the net profit margin.
Net profit margin is often called the “bottom line” of your company because it shows the ratio of your revenue you keep after deducting a large array of your expenses.
Profit margin is usually shown as a percentage, although you may see it presented as a decimal instead.
Once you’ve calculated your net profit margin, it’s time to put that percentage to good use. Your net profit margin can tell you if your business is headed in the right direction. By analyzing and reporting this number on a monthly, quarterly, and annual basis, you can see the up and down trends with your business’s health.
Profit margins will vary per industry, so it’s a good idea to review your industry’s averages to see if you’re on the right track. Industry-average margins act as benchmarks to quickly measure your business’s health.
If you have a high profit margin (relative to your industry), that’s an indicator that your business operations are efficient and healthy. A low profit margin may indicate weak sales, high expenses, incorrect pricing, or low demand for products and services—you’ll need to dive deep into the numbers and your business strategy to pinpoint the inefficiencies.
BTW, you may not be the only one interested in your net profit margin: lenders, investors, and other stakeholders use your net profit margin as an easy-to-understand metric of your business’s profitability.
While the formulas for calculating gross profit and net profit are pretty easy, tracking expenses effectively and recording sales numbers accurately can be cumbersome. Our suggestion: use a resource like the Sunrise app to take away the headache of tracking business finances. In Sunrise, both your net profit and gross profit will be found on your income statement; you’ll also see COGS and other calculations, too.
Also, in Sunrise, you’ll be able to categorize your expenses and sort your revenue sources for easy reporting and download your balance sheet and profit and loss (P&L) statement for specific periods.